Catch a falling knife? No thanks... not anymore

 

ref:- "US bond specialists warn over risks of Fed pull-out", The Financial Times, Companies and Markets

Right then, time for a very quick and ridiculously easy quiz (if just two questions can constitute a quiz)

Q. What is the overriding issue facing bond markets at this time? 

A. The Fed 's imminent start to the tapering asset purchases - okay, okay... you may have said "Inflation" but since quicker policy tightening is a result of inflation anxiety, we can say they're part of the same thing.

Q. What is the major and recurring structural problem facing bond markets, one that we return to quite a lot?

A. The hugely damaging lack of liquidity in times of stress that hugely exaggerates market moves.

The FT article alerts us to the fact that a growing number of bond-market heavyweights are concerned that if the coming reduction in Fed support, even though well-signposted, brings on panicky conditions and is joined by a sudden withdrawal of liquidity (as recent history would suggest is likely), then chaos may ensue.

The US Treasury market became the world's most important bond market, off the back of which other sovereign and corporate bonds are priced, not only because of its sheer size and credit worthiness, but also because of its great liquidity that enabled it to absorb shocks without gross distortion of prices. At least, that used to be the case but there have been numerous examples over recent times when lack of liquidity - which after all can be defined as the ability to trade without markedly affecting the price - saw prices get dramatically skewed. 2013's Taper Tantrum would be an apt example, but the FT points to two more recent episodes that maybe didn't catch so many headlines.

At one point towards the start of the pandemic in March 2020, when the harsh reality of the situation was being revealed and it was totally logical to expect safe-haven-inspired buying, prices moved sharply in a downward direction in a move prompted by liquidation orders in a market-place suddenly devoid of market depth. And in February of this year, a weak reception to a 7-year note auction saw prices fall to an extent generally agreed to be way out of proportion to the auction result.

So why has market liquidity in times of stress declined so dangerously? Much of the liquidity that might absorb any wave of selling has been provided by the 24 primary dealers (including all the big operations you might expect). They are tasked by the Fed to provide two-way prices in Treasuries market that in theory should support a tumbling market as their bids absorb the Sell orders of other investors. But the Dodd-Frank regulation put in place after the financial crisis of 2008 requires banks to hold a lot more capital in reserve against the debt they are naturally taking on. In short, that's too expensive a proposition and the primary dealers have drastically cut the amount of debt that they are prepared to take on in response. Our title is a little bit misleading, perhaps. As Kevin McPartland of Coalition Greenwich is quoted as saying: "The banks never were there to catch the falling knife but they certainly did act as a pretty huge liquidity buffer to the marketplace in a way they can't or won't today".

One simple answer might be to ease the current bank balance sheet rules, as many on Wall St and beyond would advocate. But given the deep scars left by financial crisis there's also a strong lobby against the easing of regulation (and the issue lies at the heart of the debate over whether to reappoint the current Fed Chairman, who is in favour of some relaxation). It's not a simple matter... everyone would surely desire a smoothly functioning Treasury market, but it would be hard to deny that the stricter regime protected the banks during the pandemic recession, and besides... changing capital requirements would put the US in violation of the post-2008 Basel Agreements.

If you just looked at the high volume figures in the Treasury market in normal conditions, you could be forgiven for wondering where it was all coming from if the banks have pulled back from much of their previous commitment. The answer is that the slack has been taken up by hedge funds and high-frequency traders. The trouble is that these guys also make themselves scarce when things get hairy. Algorithm-driven programmes close down in extreme conditions, and whatever trading method is in use, neither they nor anyone else is keen to "catch the falling knife" if they don't have to... and who could blame them?

Not everyone is pessimistic, however. Some take the view that this forthcoming round of tapering has been so well signposted that it won't cause anything like the same reaction as we saw in 2013. That does indeed sound logical, even if shows a degree of confidence in the market's sangfroid that not everybody would share. Ah, but there's also the Fed's reverse repo system, that allows banks to deposit cash with the Fed overnight in exchange for Treasuries, thus stabilising liquidity in times of crisis.

We'll see if the reverse repo system will be as effective as some believe, but Ed Al-Hussainy of Columbia Threadneedle (something of a regular bond market sage for the FT) sees it as just a backstop rather than a long-term solution to the problems that disrupt market functioning. Last word goes to him:

"This is not a market that is ready for the kind of environment that we're in where shocks are frequent. We're seeing events that are supposed to be rare occurring with unsettling frequency."